Italian banks may make the next weak spot in Europe

The Brexit vote immediately sparked speculation about which country may be the next weak spot in Europe. And increasingly, it’s clear the answer may be Italy.

Seventeen percent of bank loans in Italy are bad, according to aMonday report in the Wall Street Journal. That figure, which comes out to a combined 360 billion euros ($401 billion) in bad debt, is more than three times the bank loans that were bad in the U.S. on a percentage basis at the height of the financial crisis.

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Rome, Italy

The report comes as investors are already on edge due to an upcoming referendum on sweeping political changes and a report suggesting that Italy could be prepared to bypass European banking regulations.

The Financial Times reported Sunday that Italy might “defy the EU (European Union) and unilaterally pump billions of euros into its troubled banking system if it comes under severe systemic distress … despite warnings from Brussels and Berlin over the need to respect rules that make creditors rather than taxpayers fund bank rescues.”

Citing “several officials and bankers familiar with the plans,” the FT said Italy’s threat had raised alarm along Europe’s regulators “who fear such a brazen intervention would devastate the credibility of the union’s newly implemented banking rule book during its first real test.”

A spokesman for Italy’s Prime Minister Matteo Renzi denied the report, saying “Italy has no intention of defying Brussels on the banks. We respect the rules and prefer market solutions for our banks,” Reuters reported.

On Tuesday, Italian Economy Minister Pier Carlo Padoan said a precautionary liquidity boost was available for Italian banks if necessary, but not recapitalization, Reuters reported.

Italian banking stocks were among the worst faring stocks on the pan-European STOXX 600 index on Monday and traded mixed on Tuesday.

ECB asks Monte Dei Paschi to cut bad debt to $16.2B4 Hours Ago|00:39

Shares of Banca Monte dei Paschi di Siena tumbled on Monday and declined a further 11.55 percent on Tuesday, before being suspended, according to Reuters. The European Central Bank on Monday told BMPS that it wants it to cut the bad loans on its portfolio by 2018, and the bank has until Friday to respond to the ECB. BMPS is believed to be the oldest bank in the world and is one of Italy’s largest financial institutions.

The U.K.’s Brexit referendum has injected greater uncertainty into European growth forecasts, including Italy’s. That in turn has created worries about higher loan losses at the country’s banks, coupled with falling government bond yields that further hurt financial institutions’ margins.

EU banking union rules are designed to shift losses on to shareholders, bondholders and large depositors rather than taxpayers in the event of another financial crisis like the one experienced in 2008, when taxpayers in some countries bore the brunt of collapsing banks having to be rescued by national governments.

Italy’s banking system is considered to be one of the most vulnerable in the euro zone with a high level of non-performing loans (NPLs) — estimated to total 360 billion euros ($400.7 billion) — overshadowing the sector.

Societe Generale’s global research analysts led by Patrick Legland noted on Monday that Italy’s somewhat sclerotic banking system was “still fragile,” facing “specific headwinds related to the disposal of their NPL market, while bankruptcy processes and time for repossessions deter investors.”

Renzi makes a gamble

As well as rising financial risks, Italy is also facing potential political instability in the coming months when it is due to hold a referendum on constitutional reform, a vote seen as a make-or-break event for Prime Minister Renzi, by the end of October.

Former Prime Minister Mario Monti told CNBC at the weekend that the referendum was a “gamble.” “It is true that Mr. Renzi made a bit of a gamble by unnecessarily putting his prime ministership on the line (in the case that) he loses the referendum,” Monti told CNBC at a conference in Aix-en-Provence in France.

Citi analysts said in a note at the weekend that Italy’s constitutional referendum was “probably the single biggest risk on the European political landscape this year among non-U.K. issues, as PM Renzi’s political future may be tied to the outcome of the referendum.”

Analysts Tina Fordham, Ebrahim Rahbari, Giada Giani, Guillaume Menuet and Christian Schulz said that the vote is risky coming amid a rise in anti-establishment, populist sentiment, a factor that played a part in the recent U.K. referendum in which a slim majority voted to leave the EU.

“If Renzi loses the referendum and resigns, the resulting domestic political instability could well trigger significant financial volatility in Italy and Europe, due to the lack of obvious alternative leaders and/or the rising likelihood of the anti-establishment M5S party entering the next government. Recent polls on the referendum outcome and the poor performance of Renzi’s PD (Partito Democratico) party suggest that it is far from assured that the referendum will go Renzi’s way,” they warned.

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